Policy Failures: Land Missing
rom the Economic Equation

Edward J. Dodson

[September 2004]

At some point in the future a Congressional committee might be convened to investigate the science of economics and question its leading practitioners. With the economy sliding deeper and deeper into another period of stagflation or recession, a maverick Representative will chair this committee and ask that big question of economists: "What did you know, and when did you know it." Few economists will be required to take "the fifth." They will respond truthfully that they had no idea of what was happening. They will present mountains of data and talk about leading and lagging indicators. And, in the end they will say that for some unknown reason their economic models failed to predict what had occurred. There must have been some unaccounted for externalities with unforeseen consequences. The monetarists will blame the neo-Keynesians. The neo-Keynesians will blame the supply-siders. The supply-siders will blame the rational expectationists. The Marxists will blame the Neo-classicals. The reporters and public in attendance will understand little of what is discussed. The policymakers will make some bold statements about stimulating private sector investment and job-creation. No one will talk about how markets actually function and what can be done to prevent the massive swings that seem to accompany the so-called business cycle. Tens of thousands of people will be defaulting on their mortgage loans and be evicted after their house has been sold at foreclosure. That is one likely scenario. Is it just over the horizon, a decade away, or unlikely to occur?

By the definition economists apply to trends and events, we may get lucky and not experience a nationwide burst in housing prices. Housing affordability is, after all, a function of the interaction of several important components: household income, household savings (or access to other sources of funds for a down payment and/or closing costs); the cost of mortgage financing; and, the price paid for the housing unit. These variables respond to market forces - some are up when others are down and vice versa.

The boom in homeownership began in the United States following the Second World War. The construction of new highways connecting major cities made the development of outlying land feasible. Full employment during the war resulted in a huge pool of personal savings that banks poured into the economy. Young adults married in record numbers, purchased homes in the newly-constructed suburbs taking advantage of FHA-guaranteed mortgage loans, and bought their first automobile. Farmland contiguous to the cities was rapidly converted into tract housing, and the U.S. economy boomed - with intermittent downturns associated with the external shocks of war in Korea, war in Southeast Asia and the "rent-seeking" strategies of O.P.E.C. For over thirty years, household incomes increased as more workers were unionized and others moved into the professions after obtaining a college education. Although the price of land began to escalate, developers became more efficient, the two-income family became more the norm, and the ownership of a home became for most U.S. households the most important component of their net worth. This is still very much the case, although fewer and fewer households are experiencing significant increases in income as the years pass. A rapid concentration of wealth and of income has occurred over the last two decades, beginning with reductions in the rate of taxation on capital gains and high marginal incomes. For those Americans who rely almost entirely on wages to sustain themselves and their families, they displayed a remarkable willingness to relocate from one part of the country to another. Millions of retiring Americans have sold their homes, invested some of the gain and moved to another (usually warmer) part of the country to enjoy what years remain to them.

Whether we will experience another housing bubble in the near future is really a question of whether public policy and private sector productivity can outdistance the most basic part of the housing sector - the land market. And, unfortunately, there is virtually no understanding among policy makers of the problem, and all but a small number of economists pay virtually no attention either. Housing advocates and environmental activists seem to be the only groups aware of the importance of land and land policies. They would benefit by a better understanding of the connection between the functioning of land markets and public policies affecting land.

Here's the core of the issue. Land is fixed in supply. On a graph the "supply curve" for land is essentially vertical. Put "price" on the vertical axis. Put "quantity" on the horizontal axis. How far out the supply curve rests on that horizontal line in any given regional market depends on such factors as the extent of the highway system and mass transit, zoning, parkland, farmland preservation and urban growth boundaries and other measures that either encourage or restrict development. As demand for land goes up, the price asked tends to rise faster than other prices because there is less pressure on owners of land to bring their supply to market than there is for labor or capital goods. And, in fact, the purchase of land purely for speculative purposes is a long-established practice that is remarkably well-rewarded by the tax system. The sale of land is treated the same as the sale of a capital good (i.e., something produced by labor out of materials taken from the land). And, where the property tax is concerned, land (particularly vacant or underutilized land) is almost always grossly under-assessed, so that the effective annual tax rate is so low that owners feel no real pressure to develop the land they hold in order to offset carrying costs. The supply curve for land, given current tax policy, actually tends to lean to the left, meaning that the supply of land actually falls as land values are driven up by the combination of demand and speculation.

When investors in land have ready access to low cost credit, credit acts as an accelerant does on a fire. Fearful that land prices will climb ever higher, developers compete with one another to gain control of developable land parcels. At some point, the price of land becomes too expensive to be developed profitably. The housing market may be hit by a sudden rise in interest rates (associated with Federal deficits and a rising national debt) or an increased pipeline of "for sale" existing housing units because of the loss of a large corporate employer. Developers who have acquired land on credit but cannot profitably build housing people can afford to purchase default on their bank loans. The banks foreclosure and take ownership, then offer the land (sometimes with partially-completed improvements) at fire-sale prices that contribute to a fall in real estate prices, generally. Some of these properties may actually be sold back to the original landowners at far below the price they only recently received. This occurred in Hawaii and along the West Coast when Japanese and Korean institutional investors had to sell off assets in order to raise cash. The extent to which housing prices fall will depend, more than anything else, on how much unemployment occurs and for how long. There is much less speculative building these days than occurred even as recently as the late 1980s, and banks are prohibited by regulation (and sounder underwriting) from financing more than about two-thirds of a builder's site acquisition and development costs. There are far fewer under-capitalized savings and commercial banks still in existence today who are over-committed to real estate lending, so a downturn in housing should not result in a new round of bank closings. That prognosis would be one of very cautious optimism.

Housing bubbles can be easily prevented. In fact, a good deal of the impetus for the "boom-to-bust" type of business cycle can be easily prevented. All that is required is to restructure the way government raises its revenue. Inasmuch as land value is created by societal investment and by aggregate demand, this value is appropriately the subject of taxation. Even Paul Samuelson says so in the latest edition of his text on economics. Every parcel of land has some annual rental value (i.e., a "location rent"). Taxing the owners of land parcels at something approaching 100 percent of location rent would take away the profitability of owning land for speculation (or simply ignoring the land one owns because the cost of doing so has been so low). There would be no imputed income to be capitalized into much of a selling price. At the same time, improvements made to land parcels should be fully exempted from taxation. This would encourage owners to develop land to its highest and best use (as determined by the market, as influenced by zoning and other restrictions). Owners of land would be pressed by higher carrying costs to bring their land to market. They would either develop the land themselves or sell it to someone who will. Yet, once the land was developed, that asset would not be burdened by taxation.

There are some additional changes in public policy that ought to be implemented once the above fundamental adjustments are in place. The principle for all such changes is to remove tax burdens from produced assets and earned income flows, relying instead on location rents, user fees and the value of quasi-monopolistic licenses granted by government (e.g., taxi medallions, liquor licenses, leases of public lands, etc.).

Absent sound public policy the best we can expect is moderately effective monetary and fiscal interventions. Our economists ought to plug in the data on land markets and let us know if the stars seem to be aligning for or against a bursting of the bubble. Without a thorough analysis of land markets based on how they actually operate, economists really will not be of much help at all. As a group, they will wait until it all plays out, then try to explain why it happened and why they did not know it was about to happen.